Delta Buys Oil Refinery; Should Others Follow?

Delta Air Lines’ purchase of a refinery is being called an audacious defense against spiraling oil prices, but perhaps even bolder action is called for, given the stark U.S. East Coast energy situation. With an even larger refinery for sale just up the river from Delta’s new fuels complex, maybe the home heating oil customers of the U.S. Northeast should be pooling their funds together for a bid.

Delta’s $150 million purchase of ConocoPhillips’ Trainer, Pennsylvania, refinery, just south of Philadelphia on the Delaware River, gives the airline control over a facility with the capacity to produce more than 20 percent of the jet fuel in the Northeast region.

It’s a location where Delta has a major hub, in New York, that it has just expanded. Even counting the additional $100 million Delta has pledged to spend on upgrading the refinery, the cost of the purchase seems small compared to Delta’s $12 billion in spending on jet fuel last year, up 33 percent from the previous year and accounting for 40 percent of the airline’s costs. Payback for the investment would be astonishingly quick, given that Delta projects the asset will reduce its annual fuel expense by $300 million, even cutting its jet fuel bill by more than $100 million in 2012 based on the savings after its planned restart of the facility in the second half of the year.

But airlines aren’t the only ones facing a squeeze due to the relentless global crude oil market and the oil industry’s recent moves to exit from the refining business in and around Philadelphia. In fact, the refinery situation could cause a potential shortage of one type of clean-burning fuel—ultra-low-sulfur diesel (ULSD)—on the U.S. East Coast this year, with New York residents who rely on oil heating most at risk.

ULSD is mainly used as a transportation fuel (for trucks, buses, other vehicles with diesel engines) that has been required since 2006 by the U.S. Environmental Protection Agency as part of its program to cut harmful air pollution. But in a move that begins this year in New York and is to be phased in over the next six years in New Jersey, Maine, Massachusetts, and Vermont, states are requiring that ULSD be used for home heating, instead of high-sulfur-content conventional fuel oil.

A problem, however, is that a major supplier of ULSD to the Northeast has been Sunoco’s South Philadelphia refinery, which the company has vowed to close in July if a buyer is not found.

Last week, private equity firm Carlyle Group announced it was negotiating for possible purchase of the Philadelphia plant. If a deal were to be struck, Carlyle group would follow the lead of fellow private equity firm, Blackstone, which purchased an old shuttered Valero refinery in Delaware City, Delaware.

The stakes are high for oil consumers of the Northeast. If Sunoco’s refinery shuts down, U.S. government energy analysts project a 90,000 barrel-per-day shortage of ULSD in the Northeast this year, widening to 180,000 barrels per day by 2013. Fuel could be sent by from the U.S. Gulf Coast, but the main conduit, the Colonial Pipeline, is already near capacity and the ports in the region aren’t configured to offload a large amount of new refined fuel products.

The predictable result of the supply gap would be higher prices, for trucking, shipping, and for homes that use heating oil in the states with the new requirements. Not that high heating prices are anything new in the Northeast, the only part of the United States where a significant percentage of households still use heating oil. (In other parts of the country, natural gas and electricity are favored for heating.) Fortunately, this past winter was mild, but even so, the average price of heating a home with oil in the United States was $2,326, about 150 percent higher than the cost of heating a home with natural gas in the Northeast, the U.S. Energy Information Administration calculated.

(That disparity hasn’t been lost on customers, who have been switching to natural gas heating in droves. There was a 3 percent drop in oil heating in the Northeast this past year, a 16 percent drop since the winter of 2005-06. But some homes can’t switch because they aren’t served by gas pipelines.)

Delta is paying a price that amounts to $811 per barrel for the Trainer refinery’s daily capacity. If Sunoco’s nearby Philadelphia refinery were to be sold at a similar price, that would amount to about $270 million. That adds up to 2 percent of the $13.5 billion in heating bills racked up by the U.S. Northeast’s 5.8 million oil heating households this past mild winter.

In contrast with what Northeast heating oil consumers are paying to keep warm, maybe buying a refinery doesn’t seem like such a crazy idea.

Before all those heating oil customers band together to buy a refinery in the Northeast, perhaps they should ask themselves why facilities with replacement costs of several billion dollars would sell for such a big discount. The answer is that owning the refinery is just the start of the costs they would take on, with the largest being for imported crude oil--there's no local production, thanks to a long-term offshore drilling ban--and other energy and inputs to run it. They would also need to think about the investments that will be required to meet future environmental regulations. What matters to the refinery owner, as Delta will learn, is margins, and those haven't been high enough for ConocoPhillips or Sunoco to justify continuing to operate these refineries themselves.